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Nonlinearities and Asymmetric Adjustment to PPP in an Exchange Rate Model with Inflation Expectations

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  • Christina Anderl
  • Guglielmo Maria Caporale

Abstract

This paper estimates a model of the real exchange rate including standard fundamentals as well as two alternative measures of inflation expectations for five inflation targeting countries (UK, Canada, Australia, New Zealand, Sweden) over the period January 1993-July 2019. Both a benchmark linear ARDL model and a nonlinear ARDL (NARDL) specification are considered. The results suggest that the nonlinear framework is more appropriate to capture the behaviour of real exchange rates given the presence of asymmetries both in the long- and short-run. In particular, the speed of adjustment towards the PPP-implied long-run equilibrium is three times faster in a nonlinear framework, which provides much stronger evidence in support of PPP. Moreover, inflation expectations play an important role, with survey-based ones having a more sizable effect than market-based ones. Monetary authorities should aim to achieve a high degree of credibility to manage them and thus currency fluctuations effectively. The inflation targeting framework might be especially appropriate for this purpose.

Suggested Citation

  • Christina Anderl & Guglielmo Maria Caporale, 2021. "Nonlinearities and Asymmetric Adjustment to PPP in an Exchange Rate Model with Inflation Expectations," CESifo Working Paper Series 8921, CESifo.
    • Handle: RePEc:ces:ceswps:_8921
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    More about this item

    Keywords

    nonlinearities; asymmetric adjustment; PPP; real exchange rate; inflation expectations;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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